Equity investors have helped to deliver many public sector infrastructure projects via the Private Finance Initiative and have managed them in ways from which the public sector can learn. Against a background of limited information, evidence gathered by the National Audit Office raises concern that the public sector is paying more than it should for equity investment.
Banks or bondholders provide around 90 per cent of the project funding for a PFI project on the condition that the remaining money is provided by the investors as risk capital or equity, which will be lost first if the project runs into difficulty.
Investors are rewarded for taking risks. The risks the investors bear are mainly the costs of bidding; that their contractors may fail to perform; or that other project costs the investors bear the risk for will be higher than envisaged. However, the investors limit their risk by passing it to their contractors. In addition, the government is a very safe credit risk and many projects such as hospitals and schools are repeat projects.
The Treasury and departments to date have relied on competition to secure efficient pricing of the contract but have not gathered systematic information to prove the pricing of equity is optimal. The NAO report identifies three potential inefficiencies in the pricing of equity. These are the time and costs of bidding; minimum rates set by investors, which sometimes do not reflect the actual risks the project will face; and bank requirements.
Today’s report concludes that, generally, public sector authorities have not been equipped with the skills and information required to challenge investors’ proposed returns rigorously. The NAO shows how further analysis during the bidding process would help authorities to assess the reasonableness of the investor returns. As an illustration, the NAO estimates that around 1.5 per cent to 2.2 per cent of the annual service payments in three projects it analysed were difficult to explain in terms of the main risks investors said they were bearing.
Some investors in successful projects have gone on to sell shares in their equity to release capital and fund new projects. This has also resulted in accelerating the receipt of their returns. Analysis by the NAO has shown that investors selling shares early have typically earned annual returns of between 15 per cent and 30 per cent. The NAO recommends that the Treasury should use its current review of PFI to consider alternative investment models that limit the potential for very high investor returns in relation to risk.